Contrary to conventional cliché, there is very little that is binary about venture investing outcomes. It is not just feast or famine. Rather, outcomes are diverse and asymmetric. You can lose your entire investment, just lose a portion, break even, receive periodic distributions producing double-digit IRRs or achieve exits at 5X, 10X, 20X multiples or greater on your initial investment.

What does appear to be binary is the manner in which prospective investors in private ventures perceive the asymmetric return profile of venture investment outcomes….most either adore it or abhor it.

On one hand, an investor like Jim Rogers is attracted to what he no doubt views as a positive asymmetric profile of venture investment outcomes. His venture acumen began developing at the age of five by selling peanuts and by picking up empty bottles that fans left behind at baseball games. In 1970, he co-founded the Quantum Fund. During the following 10 years the portfolio gained 4200% while the S&P advanced about 47%. Nice.

In a recent rant Rogers opined not only that “diversification was garbage”, but also went on to say that “you only need four or five good ideas in your life to get really rich”.

(Note that Rogers says “really” rich…which seems a bit elitist seeing as how only one or two good ideas can make one simply rich.)

Nevertheless, 90X returns over the S&P implies that he had very little fear of placing losing bets.

But what about those less adventurous souls that eschew positive asymmetric return scenarios in favor of more traditional investments with binary and symmetrical outcomes? Why are there so few angel and venture investors despite the compelling data of the asset class’ returns and the proven history of private enterprise as the single greatest creator of family wealth?

Economics psychologist Daniel Kahneman explained this behavior with his 1979 nobel-winning, Prospect Theory which describes decisions between alternatives with uncertain outcomes where the probabilities are known. In prospect theory, Kahneman identified Loss Aversion–people’s tendency to strongly prefer avoiding losses to acquiring gains. In fact, studies suggest that losses are twice as powerful, psychologically, as gains.

In their perpetual pursuit to mirror the risk-free rate of return, some investment advisors are factoring prospect theory and loss aversion into their asset-allocation schemes. But loss aversion studies opposing symmetrical outcomes…such as either winning $100 or losing $100. It provides little insight with respect to investor’s fear of positive asymmetric return profiles.

I prefer the wisdom in David Gal’s 2006 study, A Psychological Law of Inertia and the Illusion of Loss Aversion, which discounted loss aversion as “superfluous” and found instead that risk/return tradeoff decisions were decidedly “influenced by a tradeoff between the status-quo and change”. Gal calls it inertia, noting that that people will tend to remain at the status-quo when they have no clear preference between the status quo and an alternative option.

The rigid portfolio allocation to the same traditional asset classes within the same stale strategic asset allocation model is the status quo that Gal is referring to. The results have been far from compelling yet most investors, and their advisors, keep doing the same thing while expecting different results.

In a recent WSJ article, Jason Zwieg accounts for this “mental lazziness” that prevents  investors and advisors from challenging their status quo approach to investing (and consequently, not embracing alternative asset classes and strategies). “In short, your own mind acts like a compulsive yes-man who echoes whatever you want to believe. Psychologists call this mental gremlin the confirmation bias…people are twice as likely to seek information that confirms what they already believe as they are to consider evidence that would challenge those beliefs.”

Try Harder. Properly allocated, private equity and venture investments can materiality improve a portfolio’s risk/return tradeoffs and benefit from the proven superior performance of the asset class. But, expanding your repertoire by opening your portfolio to private investment opportunities requires commitment and effort to educate yourself on the rules of the engagement and evaluation.

Achieving superior returns by embracing private investment requires initiative…not inertia.

Album: Underachievers Please Try Harder, Camera Obscura, 2004

As my career has been largely devoted to the intersection of money management and venture finance, I am no stranger to the independent RIA universe.

I have worked with dozens of wealth managers and family offices that regularly evaluate and allocate to private venture investments. Although they represent a fraction of the RIA universe, they are invariably among the most successful of their peers. These progressive wealth managers represent the primary audience of this blog.

I regularly advocate that RIAs that possess the requisite mandate, the means and the mindset should embrace private venture investments–for the benefit of their client’s portfolios, as well as, their practices. Yet, the majority of independent wealth managers should best leave this sandbox to VCs and angel investors.

Does your advisory practice possess the rationale and the resources to advise clients in start-up, early-stage and other private venture investments?

Your advisory practice may be uniquely qualified, if you consider:

• (To begin by stating the obvious…) You are in the business of wealth preservation and wealth creation.  Without question, the primary source of family wealth in America is the result of private enterprise and private venture investments characterized by their potential for positive asymmetric outcomes.

• You embrace Modern Portfolio Theory.  Despite its flaws, MPT advocates diversification into non-correlated asset classes. One-off investments in private ventures are distinctly non-correlated to broader asset classes and major market indices and have exhibited less correlation during negative black swan events.

• You possess the proper due diligence skills.  In addition to those skills you also posess the doubting disposition that is critical in evaluating private investments. The skills that advisors have developed in the course of investment manager evaluation are relevant and applicable to the private equity universe. Moreover, your experiences have taught you to be cynical and skeptical of assumptions regarding future performance.

• You are an entrepreneur.  As an independent wealth manager have chosen to compete in a highly-competitive, low margin industry. Your personal experiences should render you more prone to recognize the prerequisite personality traits of a successful entrepreneur…de rigueur in the executive team due dilly process. You also recognize the mission-critical elements beyond the strengths of the management team that determine the probability of successful enterprise.

• You understand finance.  As a stock, sector and industry analyst you know your way around balance sheets, cash flow, valuation issues and income statements. I am frequently surprised at the number of professional private venture investors that have little understanding of business and finance.

• You possess both an awareness of regulatory issues and a fiduciary responsibility that is consistent with the best practices of seasoned angel investors and VCs.

• You are networked. Beyond your practice, you have access to an expansive network of tools, resources and expertise that are essential to evaluating new technologies, industry sectors, new business models, intellectual property and other elements of private investment. Your industry colleagues offer incomparable access to the analysts, research, legal and domain expertise that is required in the course of successful private investing.

• You have access to the critical resources.  As an independent wealth manager you have enviable access to the two most important resources of private investment….investor capital and deal flow. Your HNW clients most likely became HNW clients as a result of their own ventures in private investment. Serial entrepreneurs and HNW investors are an excellent ongoing source of deal flow.

Advisors that affirmatively identify which each of these traits may have the mandate and the means to expose their client’s portfolios to the asset class that has historically created the vast majority of our nation’s private wealth and can dramatically differentiate your practice from its peers.

More advisors should explore asset allocation beyond the lame limitations of highly-correlated asset classes, stale style boxes and pointless pie charts.

Album:    Playing the Angel, Depeche Mode, 2005

Broker Model Needs Repair (Financial Post)

“By charging you 1% annually to manage your money, a large portion of your wealth ends up in his or her pocket.”

Financial Advisers Face a Crisis of Confidence (Investment News)

“About 80% of affluent investors — that is, those with more than $500,000 in investible assets — are disgusted with their adviser because their adviser is spooked”

Album:   Read All About It, The Newsboys, 1988

In a video interview about the column, Jeff Goldberg, the article’s author, describes garden-variety vendors of investment advice as, “…these Jiffy Lube kind of places. They’ll take your money. They’ll invest it in the same things that everybody else is being invested in.”

Is that a cruel but fair commentary? It is if advisors keep doing what they have been doing yet (insanely) hope for different results…and good luck securing new clients amidst the new prevailing wisdom. Face it, with the exception of advisors that embraced alternative asset classes and/or market timing, the vast majority of advisors portfolios were marked to market in the selloff and their clients have likely lost a generation of investment opportunity that may never be made up.

In prior posts we have posited and proofed the problem;

• Stocks are not worth their risk premia and bonds look downright scary.
• MPT, B&H and traditional asset allocation models have been completely discredited
• Diversification is not easily achieved because in crisis all correlations go to one.

But we also spoke to the solution;

• The vast majority of private wealth in America is the result of participation or investment in private venture….such as business start-ups, venture capital and private equity.
• The HNW investor understands and appreciates the wealth-creating potential of private venture investing (PVI)…in many cases that is how they became wealthy.

Advisors could materially improve their value proposition, their competitiveness and their client’s portfolios by developing PVI competency and integrating the asset class into their practices.

Why I Hired My Advisor

I know too well that this message will be lost on 80% of advisors who view private investments (in start-up or existing businesses, private equity or venture capital) as a new problem, rather than a solution. That’s probably the way it should be as it is likely that only 20% of IAs possess the capacity and the client-base that could support and embrace the asset class.

But every advisor benefits from a discussion that introspectively considers the true value proposition that they provide to their investment client. Invariably, portfolio performance (relative to client objectives) will always be a factor that advisory clients consider when they evaluate their advisors. Advisors should be open to asset classes that have a proven history of being non-correlated to equity markets and providing exceptional relative and absolute returns over intermediate-term market cycles.

The performance of the private investment category is indisputably compelling and speaks for itself. The most recent Thomson Reuters US Private Equity Performance Index data released through 2008 show the “All Venture” category (which includes data from early/seed, and later-stage VC funds) returned 17% over the last 20 years against the 6.1% return of the S&P. Over return periods less than 20 years the performance relative to equity indices has been even more compelling.

Venture Populist seeks to assist advisors (and investors) by advocating the integration of private venture investing into more investor relationships and portfolios and providing a forum and resource for like-minded professionals and investors.

Advisors that allocate to private venture investments claim that they differentiate their practice (from their advisor peers that are pursuing the same HNW clients) and strengthen their advisor-client relationships by increasing the quantity and quality of the advisor-client dialogue.

Private wealth and family office portfolio managers consistently maintain that the majority of their client dialogue (at the portfolio level) is spent discussing private investments. Have you ever noticed your reflection in the glazed pupils of investor’s faces when you discuss Modern Portfolio Theory or the Efficient Market Hypothesis? That’s a monologue. Discussing the prospects of a private investment in a start-up, emerging or established business…with a HNW investor who made his money in business…and you have dialogue. Business people enjoy talking about business. That provides the advisor with an excellent opportunity to engage clients on a different level than advisor-client, vendor-customer, or salesmen-prospect. Rather, as two professionals contemplating a joint business transaction.

In subsequent posts I will speak to additional ways that an advisor’s practice is positively impacted through PVI including;

• Better client retention rates,
• The development of a collaborative client “community” within the practice,
• Incentivizes for clients to refer new clients to the practice, and most importantly,
• The increased potential for improved portfolio performance,

…while radically differentiating his practice from his peers and invigorating the value proposition to the client.

Album:   Private Practice, Dr. Feelgood, 1978